Interesting Roundtable discussing banks, credit, etc...

[dcollon]

http://www.charlierose.com/view/interview/10251

 

[Parsad]

Yeah, I saw that interview on the weekend.  As I've said before, I don't like Ackman's publicity stunts, but he is a very smart guy.  Terrific speaker and his ideas on the banks are actually ones I completely agree with.  Cheers!

[ubuy2wron]

Ackman is long CDS on the banks and short some of the names a "restructuring" is a default ,it triggers his CDS he is just talking his book he throws dirt at Bill Gross who is talking his book. I think as a society we would be better off if we just gave the CDS holders a haircut if we have to choose victims here.

[dcollon]

It's also interesting to think about Mr. Buffett's comments on WFC as it relates to the whole debate.  I'm not quite sure where I come out on the whole tangible common equity to assets debate. 

 

In addition, I think people are inappropriately lumping all assets into one category.  They should be broken out and discussed individually.  i.e. C&I vs. Residential vs. Securities vs. Consumer, etc...  Not every balance sheet is the same and I don't think there is enough discussion about that concept.

 

[Parsad]

Well I think the FDIC is now attempting to do that.  Sheila Bair is looking for authority to systematically shut down the "too big to fail" institutions when they are in trouble.  Basically seeking to create a good bank/bad bank, where one side will continue to operate, while the other side with toxic or troubled assets is wound down.  Shareholders and debt holders would be on the hook for all costs.  Cheers!

 

http://www.bloomberg.com/apps/news?pid=20601087&sid=aeH.c5sqMplw&refer=home

[Guest JackRiver]

Parsad

 

What part of Ackman's nonsense on the banks do you agree with?

 

As far as I can tell, what he is advocating does not create any new capital in our banking system.  There's no high powered money save for the small fraction of cash that the banks no longer have to pay in interest.  It is true that this plan would allow for more accounting capital, but it is also true that this plan does not create any new money.  How does a country get out from under asset price deflation (credit destruction) without introducing more cash or getting the existing cash to turnover faster? 

 

The assets are still the assets, shifting around the historical accounting of the sources of those assets (Liabilities and equity capital) does not change anything but the accounting and that does nothing to help the banking system.

 

What we have here is basic banking.  At any point in time with highly leveraged institutions and in severe cases, the banking system as a whole, asset credit losses can outstrip the funding sources of those assets (liabilities and equity).  There balance sheets go upside down (insolvent).  The FED in part was created as the banker of last resort to mitigate this possibility.  With its ability to print money, the FED steps in and plugs these credit loss holes with money.  That money is new money, high powered money, whose purpose is to fill the credit holes by circulating in the economy, multiplying, and thereby combating asset price deflation.  Furthermore, the FED pulls down interest rates allowing for wider net interest margins (more profit spread on the remaining good assets and any new loans).

 

In the end, the FED will supply the money.  Arguments between nationalization/ no nationalization or debt equity swaps are mute.  These arguments are solely the FEDs personal preference but by themselves have zero economic substance.  What the FED will do is decide what form it wants.  For example:  Are Citi's credit losses so abhorrent that we want to dissolve there current corporate structure thereby penalizing there equity owners, employees, bondholders, etc. or do we keep them in tact.  Either way the FED (treasury and taxpayer also) will be supplying the money to fill in the credit holes. 

 

Ackman is a crook looking to get a trigger on his CDS.  His ideas do nothing to solve our economic troubles or the banking crisis.  He's suggesting moving deck chairs around on the titanic in the hopes that it will trigger an obscure clause in his insurance contract on proper deck chair arrangement.  The only way to keep the ship up is to plug the leak and that has nothing to do with the arrangement of the deck chairs.

 

BTW, I asked a question a month or so ago about how the TARP gives money at 5% and banks loan at 5% and how this seemingly confused math gets us out of our economic slump, I got a few answers that were all wrong and no right answers which suggested to me that no one here actually understands banking.  I know WFC and Warren Buffett understand banking.  I know from their actions that our government (FED and Treasury and even Congress) understands banking.  So why doesn't this board?  Why doesn't Ackman?  Because he's a fraud, or else, he understands full well what conditions his CDS pays out under. 

 

Yours

 

Jack River

[Rabbitisrich]

JackRiver, I disagree on the point that how the FDIC (i.e. government) funds the system has no economic impact. Imagine a prepackaged bankruptcy in which equity, debt, and counterparties take severe haircuts. The result is a massive refocusing of capital into the fractional banking system. However, you risk systemic negative feedback from all sources of bank capital ex depositors, and the banking system becomes bloated from public capital. In contrast, the current modus operandi uses public capital to float debtholders and counterparties. Pimco has been very open about the moral hazard of this strategy. You also increase the risk of politicization of the banking system, and of zombie banks. Depending on the execution of the stress tests, we may also see the risk of "checklist" management of private companies.

 

To make things more complicated, there may not be a right solution for all times. Perhaps the government needed to save debt and counterparty agreements in 2008 because of the fevered atmosphere. And likewise, perhaps the government can, and should, minimize the use of public capital by drawing from debtholders and counterparties once the economy settles down.

 

[eggbriar]

I agree with Ackman.

 

1st, you have to become solvent through fixing your balance sheet. 

 

This can be accomplished either through an

outright gift from the government or the more traditional way through bankruptcy,

converting debt into equity.

 

No one is going to contribute more cash until there is some real equity to buy or claim.

Continued borrowing just digs a deeper hole, unless you have a simple cash flow issue. 

 

If the debt holders convert their debt to equity at a sufficient

discount, you now have positive equity and have fixed your balance sheet.  Now,

if you need to raise cash, you can find investors that will buy into this equity or

loan against it.  Now you have your cash to loan out.

 

It all comes down to who will take the loss.  Why shouldn’t the loss be taken by

The debt and equity holders?

 

Greg

 

 

[Parsad]

Gee Jack, I'm glad your quite open-minded about all of this!

 

What I completely and utterly agree with Ackman is that SOME of the banks need to be recapitalized by issuing equity for debt.  This does two things:

 

One, it aligns the bondholder interests with the progress of the bank.  Why should bondholders get a free ride from taxpayers?  Equity shareholders have been or will be ultimately wiped out...either by more preferreds issued to the government for capital injections, or equity issues in the open market if they can raise capital. 

 

Two, banks are no longer on the hook for massive interest payments or possible calls on their loans.  Why would depositers put their money with a financial institution if it is still in difficulty and the government has to constantly pour more capital in?  This also reduces the amount of leverage the banks are exposed to.

 

Ideally banks should be only in the lending and deposit taking business.  Esoteric products and mortgages is not what banks need to be involved with.  They should be simple, slightly leveraged businesses, where over time they make decent returns on lending and deposit spreads.  The balance sheet should not be obfuscated with off-balance sheet items.  I'm not sure Ackman said anything entirely different than that.  Cheers! 

[Viking]

Jack, here are a couple of comments:

 

"BTW, I asked a question a month or so ago about how the TARP gives money at 5% and banks loan at 5% and how this seemingly confused math gets us out of our economic slump, I got a few answers that were all wrong and no right answers which suggested to me that no one here actually understands banking." If you are asking, yes, I am not an expert on banking. That is one of the reasons I like this board... a chance to learn some things I didn't know.

 

"I know WFC and Warren Buffett understand banking.  I know from their actions that our government (FED and Treasury and even Congress) understands banking." Perhaps I am taking you out of context, but from the little that I think I know, is the Fed, Treasury and Congress not largely the reason we are in such a mess (i.e. took interest rates to 1%, removed the regulations, allowed the leverage, allowed the derivatives, turned a blind eye to the obvious excesses...)? You may want to read some of John Hussman's stuff... he is not such a fan of what these three groups have been doing recently. But he may not understand things so well either...

[Guest JackRiver]

Since everyone is in somewhat disagreement with my point of view, I will respond in a general way.

 

First, let's take off the table any debate on what bank and banking activities should entail.  Yes, the repeal of Glass-Steagall was an atrocity and yes it greatly aided the crisis we are facing today.  You'll get no argument from me on that front.  But, what is done is done.  That debate is a day late and a dollar short.  Any further talk of what the business of banking should entail is fine, but it is a completely separate topic in relation to that of solutions to the current credit crisis we are in.  That is to say, one is a mechanism to try to limit crisis and the other is a debate on what to do now that we are already neck deep in mud.  At this stage, advising people to not walk in swamps is largely rhetorical and those advancing those arguments are either misguided or crooked or both.

 

Second, it is important to not confuse solutions to a single case event with that of solutions for a systemic event.  If a cancer has spread throughout the body, proceeding to part out limbs is not a workable solution.  I believe the plausibility of Ackman's bullshit stems from peoples misguided focus on how a bank works from that of how our banking system works.  We are not dealing with an insolvent bank per se, we are dealing with wide scale systemic credit destruction.

 

Third, If you can come up to view the crisis from thirty thousand feet instead of one foot, you will realize that there is no substantive difference between debt capital, deposit capital, preferred capital, or equity capital.  For the banking system as a whole, capital structure and cost of capital will largely be dictated by cost of deposits, and right now, that cost is less than 2% on average.  At the end of the day, the capital in the system will net back to bank deposits.  That is to say, every asset purchase is an asset sale, and every sale is an exchange of cash, and that cash, by days end, has to go somewhere (even if only for the night).  And every night you end up, net, exactly were you were the night before.  [ this third point is why I'm convinced that Warren Buffett understands banking, why WFC understands banking, why the FED and Treasury and congress understands banking.  It will also aid in understanding how, if distributed banking system wide, money from TARP etc at 5% or even 9% loaned out at 5% is net profits for the banks as long as they continue to make more loans.]  Why do you think Well's put its foot on the accelerator?  Why do you think Warren Buffett talked about net interest margin in his Fortune interview?  Why do you think our FED, Treasury, and Congress put this plan in place?  Because they understand banking. 

 

Fourth, systemwide credit destruction can only be resolved by introducing new money or effecting increased velocity of money or some combination of both.  An introduction of new money that does not turn over at least once is equivalent to "no" new money.  Again, this is the only way to fill in large system wide credit holes, and only the FED, in our system, can introduce new money.

 

Fifth, swapping out debt for equity.  I think what we are really talking about here is the government swapping its preferreds for equity which at the end of the day makes more permanent the governments capital and frees up a marginal amount of capital by reducing dividend payment to the government and reduces marginally the cost of this capital (as long as banks made loans with the Tarp money the cost is already well below 5%).  As for debt to equity swaps, dumb Ackman's view, it does not free up more capital to be leant out nor does it change the net positions of the banking system.  Think about point three above. 

 

Sixth, even if you don't follow the above, as a contrarian you should be able to decipher the 60/40 end of things given anecdotal data on what the masses/dunces believe to be the right thing to do.

 

Please, anybody trying to make points on what banks should and shouldn't be involved in is just wasting peoples time and energy in the midst of a crisis.  Agreeing with Ackman's suggestions on what banking should look like is no different than wasting time agreeing with me that people shouldn't do stupid things.  The question of the day is what should we do now, now that we are in the midst of the crisis, and do Ackmans suggestions pertaining to this question have merit?    It's strange to avoid that question, but then again, small minds are easily distracted and molded by compliance partitioners as skilled as Mr. Ackman.  I too agree with him on the irrelevant points.  What a waste. 

 

Yours

 

Jack River

[Partner24]

At this stage, advising people to not walk in swamps is largely rhetorical and those advancing those arguments are either misguided or crooked or both.

 

Please, anybody trying to make points on what banks should and shouldn't be involved in is just wasting peoples time and energy in the midst of a crisis.

 

No.

 

Human minds can think about different things at once. There is not only once section in your daily newspaper.

 

You have a patient that has a lung cancer at your surgery table. You want to have skilled surgeons to remove the cancer, but it doesn't mean that some other people cannot think about solutions to avoid the repeat of this problem in the future.  And no, this is not a waste of time and energy and no, this is not rethorical. To not do that would be a huge waste of money and energy spended. "Hey, we'll pay a lot of money to remove your cancer, but we tough we didn't have time to think about prevention, so keep smoking your huge cigars several times per day, the surgeon table will be ready for you next time".

[Guest JackRiver]

Partner

 

Can you go back and read the first point in my post and tell me if your reply still holds?

 

Specifically, "Any further talk of what the business of banking should entail is fine, but it is a completely separate topic in relation to that of solutions to the current credit crisis we are in.  That is to say, one is a mechanism to try to limit crisis and the other is a debate on what to do now that we are already neck deep in mud.  At this stage, advising people to not walk in swamps is largely rhetorical and those advancing those arguments are either misguided or crooked or both."

 

Look, banking is not some sort of new industry that we have to figure out what practices are good and what practices are not so good.  Our current crises is not due to a break down or flaws in long held banking standards.  It's the fact that people (regulators and bankers etc.) chose not to follow those standards and by ignoring those standards we get the crisis we have today.  Now, why we ignore long held standards would be a great topic to debate, though difficult of figure out.  That is, how can you structure incentives (system wide) so that we minimize deviations from long tested standards.  One place to start is to work out how it is we go from 20% down payments to 100% mortgages etc.  Who are the major players that break that standard down, congress, the regulators, bank executives, etc., and what were the incentives that drove them etc.  I personally don't have a clue on how to correct this, but I am convinced that a false debate about what good bank practices are are a waste of time.  I believe most knowledgeable participants already have a good grasp of that. 

 

My problem with the agreement with Ackman's comments with regards to good banking practices is that they give credibility to his comments on debt equity swaps.  I'm not even saying debt equity swaps would be bad, I'm instead trying to make the point that, net, they do nothing for the banking system as a whole.  I am confident that Ackman is aware of this, which leads me to suspect that he is more interested in his CDS.

 

Can you address Ackman's point of swapping debt on banks balance sheet for equity and how it is that will aid in the resolution of our current banking crisis?, and can you do that with regards to the points I made in the earlier post. 

 

Yours

 

Jack River

[Guest JackRiver]

Let me make one further point before any further replies:

 

I'm trying to get you guys to see that to understand the possible solutions to our current crisis you need to first start from the right perspective.  Most of the comments by others are misguided because they apply an understanding from the single bank level and not from the level of the banking system as a whole.  By doing this you will have trouble seeing that all you are doing is moving deck chairs around on the Titanic. 

 

From up high, that is a view of the entire banking system, there is no meaningful or substantive difference between the financing of assets.  That is to say, debt capital is no different from equity capital.

 

I understand people will find this fact troubling because distinguishing between debt and equity works so well at the individual bank level and more generally at the individual business level in other industries, but from the point of view of the banking "SYSTEM" the accounting is without economic substance.

 

Yours

 

Jack River

[returnonmycapital]

I think Jack makes a valid point.  Ackman is talking his book.  Debt/preferred to common swaps do nothing to augment capital in and of itself - it is all capital.  It just changes the 'overhead' on some of it from fixed cost to variable.  What it does for sure is create a credit event in the debt that is swapped (and triggers the full impact of holding CDS contracts).

 

Can someone explain what Ackman was trying to say about how swapping $1 of debt to equity creates $2 of capital - that one went right over me. 

 

 

[Guest JackRiver]

Awe shucks, that's just good ole Ackley kid showing us his command of numbers.

 

Yours

 

Jack River

[Parsad]

Can someone explain what Ackman was trying to say about how swapping $1 of debt to equity creates $2 of capital - that one went right over me.

 

Assume a bank has $10B in assets and $1B in equity.  Bondholders have $2B.  Convert $1B of debt to equity...now you have $1B in debt and $2B in equity.  Asset to equity leverage drops from 10-1 to 5-1.  The bank can actually lend twice as much now through leverage while maintaining substantially better capital ratios.  Cheers!

[returnonmycapital]

But I think he said capital, not specifically equity capital.  According to regulations, a simplified definition of bank capital includes: common/preferred (tier 1) plus debt (tier 2) plus investments in unconsolidated subsidiaries (tier 3 or total regulatory capital).  At least half of a bank's capital must be in the form of tier 1 capital, as I understand it.  This defines how much leverage a bank can implement.  Equity capital is not by itself considered total capital from a regulatory standpoint.  So, I didn't really understand what Ackman was saying.

 

[returnonmycapital]

What I think Ackman meant was that by swapping debt (tier 2) into equity (tier 1), a bank could go out and try to raise more tier 2 capital, given that there would be room for it if tier 1 was increased.  I'm not sure it would work out but that is probably his assumption.

[oldye]

debt is a liability...its what you owe, it can never be an asset...its not tier 2 capital. 

[Parsad]

But I think he said capital, not specifically equity capital.  According to regulations, a simplified definition of bank capital includes: common/preferred (tier 1) plus debt (tier 2) plus investments in unconsolidated subsidiaries (tier 3 or total regulatory capital).  At least half of a bank's capital must be in the form of tier 1 capital, as I understand it.  This defines how much leverage a bank can implement.  Equity capital is not by itself considered total capital from a regulatory standpoint.  So, I didn't really understand what Ackman was saying.

 

Yes, that is correct.  Going back to what I said:

 

Assume a bank has $10B in assets and $1B in equity.  Bondholders have $2B.  Convert $1B of debt to equity...now you have $1B in debt (Tier 2) and $2B in equity (Tier 1).  Asset to equity leverage drops from 10-1 to 5-1.  The bank can actually lend twice as much now through leverage while maintaining substantially better capital ratios.

 

debt is a liability...not an asset...its not tier 2 capital.

 

Subordinated debt is considered part of Tier 2 Supplementary Capital.  Cheers!

[oldye]

I stand corrected...but wth?

 

so you take on a million dollar subordinated note in exchange for a million dollars,  you get 1 million in cash which counts as tier 1, and the money you owe on it is tier 2 capital?  So you end up with, 2 million in capital?  This is rather confusing because they're using the same terminology as FASB 157...nm thats level 1,2,3.

 

[Parsad]

so you take on a million dollar subordinated note in exchange for a million dollars,  you get 1 million in cash which counts as tier 1, and the money you owe on it is tier 2 capital?  So you end up with, 2 million in capital?  This is rather confusing because they're using the same terminology as FASB 157...nm thats level 1,2,3.

 

Totally different.  They sound the same, but totally different.  In regards to the example, what Ackman was suggesting was you take say a $1B of the subordinated debt (Tier 2) and force them to convert to either common or preferred share equity (Tier 1).  This moves that capital from the less desired Tier 2 to the more desireable Tier 1, automatically strengthening the capital ratios so that the bank can actually lend twice as much now on that $1B of capital. 

 

This would have a dramatic effect on credit markets.  Even if the banks decided to remain conservative in the amount of credit they lent out, they would increase their lending at least by 50%, if not more.  At the same time, the taxpayers are no longer on the hook, the banks can lend more, and interest payments decrease.  Bondholders suddenly have significantly more at risk, but the fact remains that the business becomes more durable in an environment where spreads on lending and deposits would be enormously beneficial to banks.  Increased returns on capital would be retained and bank balance sheets would strengthen over time.  As long as they didn't go back to their esoteric products and mortgages...this is where the government really should step in, rather than injecting so much capital into them and preserving the bondholder's investments while stifling the actual banks future.  Cheers! 

[Rabbitisrich]

Let me make one further point before any further replies:

 

I'm trying to get you guys to see that to understand the possible solutions to our current crisis you need to first start from the right perspective.  Most of the comments by others are misguided because they apply an understanding from the single bank level and not from the level of the banking system as a whole.  By doing this you will have trouble seeing that all you are doing is moving deck chairs around on the Titanic. 

 

From up high, that is a view of the entire banking system, there is no meaningful or substantive difference between the financing of assets.  That is to say, debt capital is no different from equity capital.

 

I understand people will find this fact troubling because distinguishing between debt and equity works so well at the individual bank level and more generally at the individual business level in other industries, but from the point of view of the banking "SYSTEM" the accounting is without economic substance.

 

Yours

 

Jack River

 

 

JR, can you clarify your statement above? Are you saying that the banking system won't change if 100% of the capital came from TARP at 5% now and 9% in 2014? Or are you arguing that unorthodox capital sources are fine as long as they keep NIMs high and allow banks to earn their way out of trouble?

 

Regarding Ackman's Debt/Equity swap--ignoring moral hazard, fairness, etc..--the equity provides a greater buffer against regulatory ratios and gives banks more confidence to lend aggressively vs. building their balance sheets. It also gives them more breathing space to lend intelligently. I understand your point that Bank A can pay out interest and dividends and Banks B-Z will eventually recieve those dollars. But we've already seen how, as in the S&L crisis, banks under cost of capital pressures can make dumb decisions on the asset side.

[MartinWhitman]

Dont know if this was already posted, but there is an interesting article on portfolio.com about Bill Ackman.

 

http://www.portfolio.com/executives/2009/04/22/Hedge-Fund-Manager-Bill-Ackman